The Federal Reserve System: Purposes and Functions

demand for and supply of Federal Reserve balances that would otherwise put pressure on the federal funds rate.

Reserve balance requirements and contractual clearing balances also help create a predictable demand for balances at the Federal Reserve. Without reserve balance requirements or contractual clearing balances, many depository institutions would still hold positive balances at the Federal Reserve to facilitate payments on behalf of themselves or their customers and to avoid having a negative balance in their account at the end of the day. The exact amount of balances that depository institutions want to hold at the Federal Reserve at the end of the day for clearing purposes can vary considerably from day to day, often depending on the volume and uncertainty of the payment flows through their accounts. These demands are very difficult for the Federal Reserve to forecast. When the level of reserve balance requirements, contractual clearing balances, or the sum of the two make it necessary for depository institutions to hold balances above the shifting and unpredictable level needed for clearing purposes, the Federal Reserve can more accurately determine the demand for Federal Reserve balances and, by manipulating the supply of Federal Reserve balances through open market operations, more readily attain the target funds rate.

The remainder of this chapter takes a more detailed look at open market operations, reserve requirements, contractual clearing balances, and the discount window.

Open Market Operations

In theory, the Federal Reserve could conduct open market operations by purchasing or selling any type of asset. In practice, however, most assets cannot be traded readily enough to accommodate open market operations. For open market operations to work effectively, the Federal Reserve

must be able to buy and sell quickly, at its own convenience, in whatever volume may be needed to keep the federal funds rate at the target level. These conditions require that the instrument it buys or sells be traded in a broad, highly active market that can accommodate the transactions without distortions or disruptions to the market itself.

The market for U.S. Treasury securities satisfies these conditions. The U.S. Treasury securities market is the broadest and most active of U.S. financial markets. Transactions are handled over the counter, not on an organized exchange. Although most of the trading occurs in New York City, telephone and computer connections link dealers, brokers, and customers—regardless of their location—to form a global market.

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The Implementation of Monetary Policy

Composition of the Federal Reserve’s Portfolio

The overall size of the Federal Reserve’s holdings of Treasury securities depends principally on the growth of Federal Reserve notes; however, the amounts and maturities of the individual securities held depends on the FOMC’s preferences for liquidity. The Federal Reserve has guidelines that limit its holdings of individual Treasury securities to a percentage of the total amount outstanding. These guidelines are designed to help the Federal Reserve manage the liquidity and average maturity of the System portfolio. The percentage limits under these guidelines are larger for shorter-dated issues than longer-dated ones. Consequently, a sizable share of the Federal Reserve’s holdings is held in Treasury securities with remaining maturities of one year or less. This structure provides the Federal Reserve with the ability to alter the composition of its assets quickly when developments warrant. At the end of 2004, the Federal Reserve’s holdings of Treasury securities were about evenly weighted between those with maturities of one year or less and those with maturities greater than one year (table 3.3).

Table 3.3

U.S. Treasury securities held in the Federal Reserve’s open market account, December 31, 2004

Billions of dollars

The Conduct of Open Market Operations

The Federal Reserve Bank of New York conducts open market operations for the Federal Reserve, under an authorization from the Federal Open Market Committee. The group that carries out the operations is commonly referred to as “the Open Market Trading Desk” or “the Desk.” The Desk is permitted by the FOMC’s authorization to conduct business with U.S. securities dealers and with foreign official and international institutions that maintain accounts at the Federal Reserve Bank of New York. The dealers with which the Desk transacts business are called primary dealers. The Federal Reserve requires primary dealers to meet the

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The Federal Reserve System: Purposes and Functions

capital standards of their primary regulators and satisfy other criteria consistent with being a meaningful and creditworthy counterparty. All open market operations transacted with primary dealers are conducted through an auction process.

Each day, the Desk must decide whether to conduct open market operations, and, if so, the types of operations to conduct. It examines forecasts of the daily supply of Federal Reserve balances from autonomous factors and discount window lending. The forecasts, which extend several weeks into the future, assume that the Federal Reserve abstains from open market operations. These forecasts are compared with projections of the demand for balances to determine the need for open market operations. The decision about the types of operations to conduct depends on how long a deficiency or surplus of Federal Reserve balances is expected to last. If staff projections indicate that the demand for balances is likely to exceed the supply of balances by a large amount for a number of weeks or months, the Federal Reserve may make outright purchases of securities or arrange longer-term repurchase agreements to increase supply. Conversely, if the projections suggest that demand is likely to fall short of supply, then the Federal Reserve may sell securities outright or redeem maturing securities to shrink the supply of balances.

Even after accounting for planned outright operations or long-term repurchase agreements, there may still be a short-term need to alter Federal Reserve balances. In these circumstances, the Desk assesses whether the federal funds rate is likely to remain near the FOMC’s target rate in light of the estimated imbalance between supply and demand. If the funds rate is likely to move away from the target rate, then the Desk will arrange short-term repurchase agreements, which add balances, or reverse repurchase agreements, which drain balances, to better align the supply of and demand for balances. If the funds rate is likely to remain close to the target, then the Desk will not arrange a short-term operation. Short-term temporary operations are much more common than outright transactions because daily fluctuations in autonomous factors or the demand for excess reserve balances can create a sizable imbalance between the supply of and demand for balances that might cause the federal funds rate to move significantly away from the FOMC’s target.

Outright Purchases and Sales

The Federal Reserve tends to conduct far more outright purchases than outright sales or redemptions of securities primarily because it must offset the drain of balances resulting from the public’s increasing demand for Federal Reserve notes (table 3.4). When the Desk decides to buy securities in an outright operation, it first determines how much it wants to buy to address the mismatch between supply and demand. It then divides that

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The Implementation of Monetary Policy

amount into smaller portions and makes a series of purchases in different segments of the maturity spectrum, rather than buying securities across all maturities at once, in order to minimize the impact on market prices.

When the projections indicate a need to drain Federal Reserve balances, the Desk may choose to sell securities or to redeem maturing securities. Sales of securities are extremely rare. By redeeming some maturing securities, rather than exchanging all of them for new issues, the Federal Reserve can reduce the size of its holdings gradually without having to enter the market. Redemptions drain Federal Reserve balances when the

Treasury takes funds out of its accounts at depository institutions, transfers those funds to its account at the Federal Reserve, and then pays the Federal Reserve for the maturing issues.

Table 3.4

Federal Reserve System outright transactions, 2001–2004

Billions of dollars

Purchases from and sales to foreign official and international customers enable the Federal Reserve to make small adjustments to its portfolio without formally entering the market. These transactions occur at market prices.

The size of the buy or sell orders of these customers and the projected need for open market operations determine whether the Desk chooses to arrange these customer transactions directly with the Federal Reserve, in which case they affect Federal Reserve balances, or to act as agent by conducting the transactions in the market, with no effect on balances.

Repurchase Agreements

The Federal Reserve frequently arranges repurchase agreements to add Federal Reserve balances temporarily (table 3.5). In these transactions, it acquires a security from a primary dealer under an agreement to return the security on a specified date. Most repurchase agreements have an overnight term, although short-term repurchase agreements with maturities of two to thirteen days are also arranged to address shortages in Federal Reserve balances that are expected to extend over several days. Longer-term repurchase agreements are used to address more-persistent needs. The Federal Reserve accepts Treasury, federal agency, and mort-

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